Defense Industry Challenges

The business of defending,

This is the first in a series of articles about the inflation challenge within the defense industry.

Inflation continues to run above historical averages. The general public is feeling the pinch, with the consumer price index up 8.3 percent over the past year.1 Within the aerospace and defense sector, leaders are trying to adjust to an inflation level that many have never encountered in their careers.

The producer price index (PPI), which measures the prices received by domestic US businesses for their output, has increased 12.2 percent for goods and 6.8 percent for services over the past year.2 Input costs for common defense products and services have risen even higher, with increases of 10.0 percent for industrial chemicals, 17.8 percent for transportation and warehousing, and 25.9 percent for energy.

Rising costs may ultimately cut into the US Department of Defense’s (DOD’s) buying power. In an earlier analysis, we estimated that the agency could lose more than $100 billion in purchasing power within five years if the economy reenters a period of high inflation and the defense budget is limited to nominal top-line increases, similar to what happened in the 1970s.3 In that scenario, the DOD would have limited funds to invest in modernizing military equipment, especially since the department would still have to increase military pay to meet mandatory requirements. Defense companies would then face lower demand on top of increased input costs.

Today’s soaring prices come after many years of relatively low inflation and have prompted the US Federal Reserve to raise interest rates more rapidly than any time in the past two decades.4 While many businesses are also revisiting their strategies in response to inflation and rising interest rates, the path ahead for defense companies may be particularly complicated. Most of their contracts specify that the DOD will pay a fixed price for goods and services over a relatively long period, so they cannot compensate for higher costs by increasing prices. As defense companies begin to formulate a response to inflation, they will benefit from a strong understanding of their contract portfolio, including how common terms may impose constraints when developing a strategy to deal with rising prices. This understanding will help them work with the DOD to maximize the nation’s defense systems. ... '